Liquidity risk on regulators' radar

The need for financial institutions to evolve their management of liquidity risk as the interest rate environment continues its uncertain road to a new equilibrium is a key focus for regulators in the UK and around the world.

This was the message from Dave Ramsden (pictured), Deputy Governor, Markets and Banking at the Bank of England, when he was a panellist at the recent European Systemic Risk Board (ESRB) conference, writes Contributing Editor David Worsfold.

He highlighted some of the key trends that the Bank was seeing emerge during the transition from the post-financial crisis low interest rate regime to the higher rate environment the world now finds itself expecting to last for some time yet. This put various aspects of liquidity risk firmly on the regualtory radar screen, said Ramsden. This includes a steady rise in term premia – the additional compensation that investors require to hold longer-term bonds – which he said has been significant factor in recent rises in longer-term global yields:

Dave Ramsden front“In part, that could reflect increased uncertainty around the economic outlook and interest rates, as well as an evolving assessment of the balance of supply and demand in government bond markets. Since we completed the MPC’s November forecast there has been some fall back in global yields which may reflect a partial unwinding of some of these shorter-term factors.”

He said this must be put into context as it accounts for only a small proportion of the overall rise in longer-term UK and US government bond yields over the past two years, relative to the contribution from the rise in expected policy rates. This is one of the shocks to the system that has impacted liquidity and which regulators are monitoring closely, said Ramsden:

“Recent events have revealed that shocks can uncover vulnerabilities, exacerbating rapid or sharp moves in market interest rates – independent of the impact of monetary policy – leading to additional liquidity stress in the financial system, harming the functioning of core markets … there is ongoing work at central banks to address the vulnerabilities that these events revealed.”

This brought him to the central theme of his presentation during a panel session appropriately titled ‘Evolution of liquidity risk in an environment of higher interest rates’, stressing that this was not just an issue for banks but a wide range of financial institutions, including insurers.

“Liquidity risk is a very old concept, but as markets have evolved so have the liquidity risks the financial system faces. Central bankers as lenders of last resort have always been concerned with liquidity risk and my predecessors in Threadneedle Street have been responding to liquidity risk for centuries.

“But the nature of liquidity risk in the financial system has changed over time, including in the relatively short period since the global financial crisis. In particular, banks, insurers and central counterparties both in the UK and globally are generally better regulated and more resilient to shocks, including liquidity shocks, than they were prior to the crisis.”

Regulation in the UK has evolved – and will continue to evolve – said Ramsden, highlighting the regimes governing insurers and pension funds:

“Solvency II stipulates insurers should use fair value accounting so that losses are recognised on balance sheet immediately, and the Matching Adjustment deviates from this principle to incentivise insurers to match the duration of their assets with their liabilities. Similarly, the UK Pension Regulator stipulates that pension trustees should appropriately manage and mitigate risks, including those arising from interest rates.”

He illustrated how the Bank and its regulatory teams had responded to the volatility of recent years by ensuring the market and the key players in it remained stable and resilient. Regulatory oversight should enable the Bank to monitor liquidity risk dynamics and spot problems early enough to take effective action, although he concluded with a warning not to expect the Bank to bail firms out if they fall short on managing liquidity risks:

“The Bank will not provide insurance for individual firm liquidity mismanagement. However, when exceptional and systemic circumstances threaten UK financial stability, we stand ready to tackle these risks while ensuring that we avoid creating new forms of moral hazard: going with the flow but not adding to it.”

• The ESRB conference was a virtual event with contributions from a wide range of regulators and central bankers, including Christine Lagarde, who chairs the ESRB board, and Michael Barr, Vice-Chair for Supervision, Board of Governors of the Federal Reserve System. Their contributions, along with many others, are available on the ESRB website 


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